An interest rate swap (IRS) is an example of one type of an illiquid financial product in which the parties agree to exchange streams of future interest payments based on a specified principal or notional amount. An IRS Swaps are often used to hedge interest rate risk or may be used for speculative purposes. An example of an IRS is a plain fixed-to-floating, or “vanilla,” interest rate swap. The vanilla swap includes an exchange of a stream of payments based on a floating rate with a stream based on a fixed rate. Both payment streams are calculated over a notional amount.
Usually, at least one of the legs to a swap has a variable rate. The rate is called variable because it may be reset. The variable interest rate may be linked to a periodically known or agreed upon rate for the term of the swap, such as the London Interbank Offered Rate (LIBOR). The variable rate may be based on other agreed upon factors such as a reference rate, the total return of an asset, an economic statistic, etc. Other examples of swaps include total return swaps, and equity swaps.
The expiration or maturity of the streams of payments may occur well into the future. A book of existing and new IRSs may include swaps having a variety of maturity dates. Currently, financial institutions such as banks engage in swaps in an illiquid market, where each party bears the risk of default by the other party. That is, each party bears the credit risk of having any one or all of its counterparties defaulting on the payments.
For interest rate swaps and other illiquid derivative products that are centrally cleared, the central counterparty takes on the credit risk of the parties. That is, a central counterparty may be the counterparty to each party to the IRS transaction, thereby eliminating the credit risk for each party. The central counterparty may be a clearing house, such as the clearing house of the CME Group, Inc. located at 20 South Wacker Drive, Chicago, Ill. The central counterparty may act as a guarantor to each party of the streams of payments to each. The central counterparty may mitigate its credit risks for each party by requiring each party to maintain a minimum amount of funds that are readily accessible to the clearing house. The amount of the funds may be periodically determined, such as through a periodic mark-to-mark process.
The risk to the central counterparty may exist for the life of a stream of payments. Even if one of the parties were to default on an IRS, the central counterparty would take on the position to continue to guarantee payments to the non-defaulting party associated with the IRS. To mitigate its risks, the central counterparty would liquidate the position in the market. However, for defaulted positions in illiquid markets, it may not be possible to find a reasonable liquidation for the defaulted position.
It would be desirable to provide methods, systems and processes for the administration, conversion and liquidation of defaulted open positions for illiquid markets.